Equity Analysis and Valuation
12
CHAPTER
Earnings Persistence
Recasting and Adjusting
? Earnings persistence is a key to effective equity
analysis and valuation
? Analyzing earnings persistence is a main analysis
objective
? Attributes of earnings persistence include,
Stability
Predictability
Variability
Trend
Earnings management
Accounting methods Analyze
Earnings Persistence
Recasting and Adjusting
Two common methods to help
assess earnings persistence,
? Recasting of income
statement
? Adjusting of income
statement
Earnings Persistence
Recasting and Adjusting
Information for Recasting and Adjusting
? Income statement,including its subdivisions,
Income from continuing operations
Income from discontinued operations
Extraordinary gains and losses
Cumulative effect of changes in accounting
principles
? Other financial statements and notes
? Management commentary in financial statements
? Management’s Discussion and Analysis
? Other,product-mix changes,technological
innovations,work stoppages,and raw material
constraints
Earnings Persistence
Recasting and Adjusting
Objectives of Recasting
1,Recast earnings and earnings components so that stable,normal
and continuing elements comprising earnings are distinguished
and separately analyzed from random,erratic,unusual and
nonrecurring elements
2,Recast elements included in current
earnings that should more properly be
included in the operating results of one
or more prior periods
Recasting and adjusting earnings also
aids in determining earning power
General Recasting Procedures
? Income statements of several years (typically at least
five) are recast
? Recast earnings components to yield meaningful
classifications and a relevant format for analysis
? Components can be rearranged,subdivided,and tax
effected
? Total recasted components
must reconcile to reported
net income
Earnings Persistence
Recasting and Adjusting
Specific Recasting Procedures
? Discretionary expenses are segregated
? Distinct components are segregated (such as equity in income of
unconsolidated subsidiaries) and often reported net of tax
? When components of continuing income are separately
reclassified,their pre-tax amounts along with their tax effects
must be removed
? Income tax disclosures enable one to separate factors that either
reduce or increase taxes such as,
? Deductions—tax credits,capital
gains rates,tax-free
income,lower foreign tax rates
? Additions—additional foreign
taxes,non-tax-deductible
expenses,and state and local
taxes (net of federal tax benefit)
Earnings Persistence
Recasting and Adjusting
Recasting and Adjusting -- Illustration
Earning Persistence
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
13 Net sales $ 6,204.1 $ 6,205.8 $ 5,672.1 $ 4,868.9 $ 4,490.4 $ 4,286.8
19 Interest income 26.0 17.6 38.3 33.2 29.5 27.4
Total revenue $ 6,230.1 $ 6,223.4 $ 5,710.4 $ 4,902.1 $ 4,519.9 $ 4,314.2
Costs and expenses,
Cost of products sold (see Note 1 below) $ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,820.5
Marketing and selling expenses (see Note 2 below) 760.8 760.1 605.9 514.2 422.7 363.0
145 Advertising (see Note 2 below) 195.4 220.4 212.9 219.1 203.5 181.4
144 Repairs and maintenance (see Note 1 below) 173.9 180.6 173.9 155.6 148.8 144.0
16 Administrative expenses 306.7 290.7 252.1 232.6 213.9 195.9
17 Research and development expenses 56.3 53.7 47.7 46.9 44.8 42.2
102 Stock price related incentive programs (see Note 3 below)
15.4 (0.1) 17.4 (2.7) — 8.5
20 Foreign exchange adjustment 0.8 3.3 19.3 16.6 4.8 0.7
104 Other,net (see Note 3 below) (3.3) (2.0) (1.4) (4.7) (0.4) (9.0)
162A Depreciation (see Note 1 below) 194.5 184.1 175.9 162.0 139.0 120.8
103 Amortization of intangible and other assets (see Note 3 below)
14.1 16.8 16.4 8.9 5.6 6.0
18 Interest expense 116.2 111.6 94.1 53.9 51.7 56.0
Total costs and expenses $ 5,557.9 $ 5,712.7 $ 5,266.0 $ 4,480.2 $ 4,132.2 $ 3,930.0
23 Earnings before equity in earnings of affiliates & min,interests
$ 672.2 $ 510.7 $ 444.4 $ 421.9 $ 387.7 $ 384.2
24 Equity in earnings of affiliates 2.4 13.5 10.4 6.3 15.1 4.3
25 Minority interests (7.2) (5.7) (5.3) (6.3) (4.7) (3.9)
26 Income before taxes $ 667.4 $ 518.5 $ 449.5 $ 421.9 $ 398.1 $ 384.6
Income taxes at statutory rate* (226.9) (176.3) (152.8) (143.5) (179.1) (176.9)
Income from continuing operations $ 440.5 $ 342.2 $ 296.7 $ 278.4 $ 219.0 $ 207.7
135 State taxes (net of federal tax benefit) (20.0) (6.6) (3.8) (11.8) (8.6) (8.0)
Investment tax credit — — — — 4.4 11.6
137 Nondeductible amortization of intangibles (4.0) (1.6) (1.2) (2.6) (1.4) —
138 Foreign earnings not taxed or taxed at other than statutory rate
2.0 (2.2) (0.2) 3.2 11.1 15.2
139 Other,Tax effects (17.0) (2.2) (0.1) (3.7) 7.5 (4.7)
Alaska Native Corporation transaction — — — — 4.5 —
22 Divestitures,restructuring and unusual charges — (339.1) (343.0) (40.6) — —
Tax effect of divest.,restructuring & unusual charges (Note 4)
— 13.9 64.7 13.9 — —
(Continued on next page)
Recasting and Adjusting -- Illustration
Earning Persistence
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
Gain on sale of businesses in (Yr 8) and sub,in Yr 7 — — — 3.1 9.7 —
Loss on sale of exercise equipment subsidiary,net of tax — — — — (1.7) —
LIFO liquidation gain (see Note 1 below) — — — 1.7 2.8 1.4
Income before cumulative effect of accounting change$ 401.5 $ 4.4 $ 13.1 $ 241.6 $ 247.3 $ 223.2
153A Cumulative effect of accounting change for income taxes — — — 32.5 — —
28 Net income as reported $ 401.5 $ 4.4 $ 13.1 $ 274.1 $ 247.3 $ 223.2
14 (Note 1) Cost of products sold $ 4,095.5 $ 4,258.2 $ 4,001.6 $ 3,392.8 $ 3,180.5 $ 3,082.8
144 Less,Repair and maintenance expenses (173.9) (180.6) (173.9) (155.6) (148.8) (144.0)
162A Less,Depreciation(a) (194.5) (184.1) (175.9) (162.0) (139.0) (120.0)
153A Plus,LIFO liquidation gain(b) — — — 2.6 5.1 2.6
$ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,821.4
15 (Note 2) Marketing and selling expenses $ 956.2 $ 980.5 $ 818.8 $ 733.3 $ 626.2 $ 544.4
145 Less,Advertising (195.4) (20.4) (212.9) (219.1) (203.5) (181.4)
$ 760.8 $ 960.1 $ 605.9 $ 514.2 $ 422.7 $ 363.0
21 (Note 3) Other expenses (income) $ 26.2 $ 14.7 $ 32.4 $ (3.2) $ (9.5) $ 5.5
102 Less,Stock price–related incentive programs (15.4) 0.1 (17.4) 2.7 — (8.5)
103 Less,Amortization of intangible and other assets (14.1) (16.8) (16.4) (8.9) (5.6) (6.0)
Less,Gain on sale of businesses (Yr 8) and sub,(Yr 7) — — — 4.7 14.7 —
104 Other,net $ (3.3) $ (2.0) $ (1.4) $ (4.7) $ (0.4) $
(9.0)
(Note 4) Tax effect of divest,restruc.,& unusual charges — $ 115.3(c) $ 116.6(d) $ 13.9 — —
136 Nondeductible divestitures,restructuring,and unusual charges
— (101.4)(e) (51.9)(f) — — —
— $ 13.9 $ 64.7 $ 13.9 — —
*Statutory federal tax rate is 34% in Year 8 through Year 11,45% in Year 7,and 46% in Year 6,
?This amount is not disclosed for Year 6,
(a)We assume most depreciation is included in cost of products sold,
(b)LIFO liquidation gain before tax,For example,for Year 8 this is $2.58 million,computed as $1.7/(1 0.34),
(c)$339.1 22 0.34 = $115.3,
(d)$343.0 22 0.34 = $116.6
(e)$179.4 26 0.565 136 = $101.4,
(f)$106.5 26 0.487 136 = $51.9,
Earnings Persistence
Recasting and Adjusting -- Illustration
Objective of Adjusting
Assign earnings components to periods where they
most properly belong
Note,Uses data from recast income statements and
any other relevant information
General Adjusting Procedures
All earnings components must be considered
When a component is excluded from the period when
reported,then
1,Shift it (net of tax) to the operating results of one or
more prior periods,or
2,Spread (average) it over earnings for the period
under analysis
Note,Only spread items over prior
earnings when they cannot be
identified with specific periods
Earnings Persistence
Recasting and Adjusting
Specific (Typical) Adjusting Procedures
? Assign extraordinary and unusual items (net of tax) to
applicable years
? Tax benefit of carryforwards normally moved to the loss year
? Costs or benefits from lawsuit settlements moved to
relevant prior years
? Gains and losses from disposals of discontinued
operations usually relate to operating results of several prior
years
? Changes in accounting principles or
estimates yield adjustments to all
years under analysis to a comparable
basis—redistribute ―cumulative effect‖
to the relevant prior years
? Normally include items that increase or decrease equity
Earnings Persistence
Recasting and Adjusting
Earnings Persistence
Recasting and Adjusting
Campbell Soup Company
Adjusted Income Statements ($ mil.)
Year 11 Year 10 Year 9 Year 8 Year 7 Year 6 Total
Net income as reported $ 401.5 $ 4.4 $ 13.1 $ 274.1 $ 247.3 $ 223.2 $ 1,163.6
Divestitures,restructuring & unusual charges
339.1 343.0 40.6
Tax effect of divestitures,restructuring,etc,
(13.9) (64.7) (13.9)
Gain on sale of businesses (Yr 8) and sale of
subsidiary (Yr 7),net of tax (3.1) (9.7)
Loss on sale of exercise equipment subsidiary 1.7
ANC transaction (4.5)
LIFO liquidation gain (1.7) (2.8) (1.4)
Cumulative effect of change in acctg for taxes (32.5)
Adjusted net income $ 401.5 $ 329.6 $ 291.4 $ 263.5 $ 232.0 $ 221.8
Total net income for the period $ 1,163.6
Average earnings for the period $ 193.9
Earnings Persistence
Determinants of Persistence
Earnings persistence determined by many
factors including,
?Earnings variability
?Earnings trend
?Earnings stability
?Earnings predictability
?Earnings Management
?Management Incentives
Note,Assess earnings persistence over both the
business cycle and the long term
Earnings Persistence
Measuring Persistence
Earnings variability can be measured,
1,Standard variability measures
2,Average earnings--typically using 5 to 10
years of data
3,Minimum earnings--typically selected from
the most recent business cycle,reflecting a
worst-case scenario
Earnings Persistence
Measuring Persistence
Earnings Trend can
be measured,
1,Statistical methods
2,Trend statements
(such as Index numbers)
Earnings Persistence
Measuring Persistence
Earnings Management is reflected as follows,
? Changes in accounting
methods or assumptions
? Offsetting extraordinary
/unusual gains and
losses
? Big baths
? Write-downs
? Timing revenue and expense recognition
? Aggressive accounting applications
Earnings Persistence
Measuring Persistence
Management Incentives affecting persistence include,
? Personal objectives and interests
? Companies in distress
? Prosperous companies—preserving hard-earned
reputations
? Compensation plans
? Accounting-based incentives and constraints
? Analysts targets
Earnings Persistence
Measuring Persistence
Earnings persistence of
components depends on key
attributes
Recurring vs Non-recurring
Operating vs Non-operating
Key application of these
attributes is the reporting of
Extraordinary vs Non-
extraordinary
C o m p a n i e s R e p o r t i n g E x t r a o r d i n a r y I t e m s
N o e x t r a o r d i n a r y i t e m s,
86%
E x t r a o r d i n a r y i t e m s,1 4 %
Earning Persistence
Measuring Persistence
Source,Accounting Trends & Techniques
Earnings Persistence
Measuring Persistence
Analyzing and Interpreting
Extraordinary Items
1,Determine whether an item
is extraordinary (less
persistent) or not
2,Assessing whether an item
is unusual,non-operating,
or non-recurring
3,Determine adjustments
necessary given
assessment of persistence
Earning Persistence
Measuring Persistence
F r e q u e n c y o f E x t r a o r d in a r y I t e m s
0, 0 2, 0 4, 0 6, 0 8, 0 1 0, 0 1 2, 0
De bt e x ting uis hm e nts
Loss carry forw ards
Litigation
" Othe r"
P e rc e n t
Source,Accounting Trends & Techniques
Three broad categories,
1,Nonrecurring operating gains
and losses
-Usually include in current operating
income
2,Recurring non-operating gains and losses
-Consider inclusion in current operating earnings
3,Nonrecurring non-operating gains and losses
-Omitted from operating earnings of a single year
Earning Persistence
Measuring Persistence
Earning-Based Valuation
Stock Prices and Accounting Data
Equity value (Vt)
Book value (BVt)
Return on common equity (ROCEt)
Cost of equity capital (k)
Abnormal earnings = (ROCEt - k) x BVt-1
Note,This model is algebraically identical to the
―residual income‖ model of Chapter 1
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Earning-Based Valuation
Valuation Multiples
Price-to-Book (PB)
e q u it y of va lu e B o o k
e q u it y of va lu eM ar k e t
Earning-Based Valuation
Valuation Multiples
Price-to-Book (PB) expressed in accounting data
Note
?ROCE and growth in book value increase ? PB increases
?Cost (risk) of equity capital increases ? PB decreases
?Present value of future abnormal earnings is
positive (negative) ? PB is greater
(less) than 1.0
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Earning-Based Valuation
Valuation Multiples
Price-to-Earnings (PE)
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e q u i t y of v a l u eM a r k e t
Earning-Based Valuation
Valuation Multiples
Price-to-Earnings (PE) expressed in accounting data
PE [equaling (1+k)/k] is ―normal‖ PE
? Niat+1 is the expected change in abnormal earnings
compared to the prior year (Niat+1 NIat)
dt is dividends
Note
? Cost of equity capital increases ? PE decreases
? Future abnormal earnings increases (decreases)
? PE is greater (less) than normal PE
? Current earnings increases (decreases)
? PE decreases (increases)
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Earning-Based Valuation
Valuation Multiples
Low PB High PB
?Low PE Earnings expected to grow Earnings
expected to grow slowly or decline relative to slowly
or decline relative to current level,with low expected
current level,but with high ROCE,expected ROCE,
?High PE Earnings expected to grow Earnings
expected to grow quickly relative to current level,
quickly relative to current level,but with low expected
ROCE,with high expected ROCE,
Earning-Based Valuation
Earnings-Based Valuation--Illustration
Christy Co,book value of equity at January 1,Year 1,is $50,000
Christy has a 15% cost of equity capital (k)
Forecasts of Christy’s accounting data follow,
Year 1 Year 2 Year 3 Year 4 Year 5
Sales $ 100,000 $ 113,000 $ 127,690 $ 144,290 $144,290
Operating expenses 77,500 90,000 103,500 118,000 119,040
Depreciation 10,000 11,300 12,770 14,430 14,430
Net income $ 12,500 $ 11,700 $ 11,420 $ 11,860 $ 10,820
Dividends 6,000 4,355 3,120 11,860 10,820
Year 6 and beyond = Both accounting data and dividends
approximate Year 5 levels
Earning-Based Valuation
Earnings-Based Valuation--Illustration
Christy’s forecasted book value at January 1,Year 1 is
$58,594—computed as,
This implies Christy stock should sell at a PB ratio of 1.17
($58,594/$50,000) at January 1,Year 1
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Earning-Based Valuation
Earnings-Based Valuation--Illustration
Two additional observations are important,
1,Expected ROCE equals 15% (Christy’s cost of capital) for Year 5
and beyond,Since ROCE equals the cost of capital for Year 5 and
beyond,these years’ results do not change the value of Christy (that
is,abnormal earnings equal zero for those years),The anticipated
effects of competition are implicit in estimates of future profitability,
2,Valuation estimates assume dividend payments occur at the end of
each year,A more realistic assumption is that,on average,these
cash outflows occur midway through the year,To adjust valuation
estimates for mid-year discounting,multiply the present value of
future abnormal earnings by (1 k/2),For Christine Company the
adjusted valuation estimate equals $59,239,This is computed as
$50,000 plus (1 1 [.15/2]) 3 $8,594,
Earning Power and Forecasting
Earning Power
Earning power is the earnings level expected to persist
into the foreseeable future
? Accounting-based valuation models capitalize
earning power
? Many financial analyses
directed at determining
earning power
Earning Power and Forecasting
Earning Power
Measurement of Earning Power reflects,
? Earnings and all its components
? Stability and persistence of earnings and its
components
? Sustainable trends in
earnings and its
components
Earning Power and Forecasting
Earning Power
Factors in selecting a time horizon for measuring earning
power
? One-year period is often too short to reliably measure
earning power
? Many investing and financing activities are long term
? Better to measure earning power by using average (or
cumulative) earnings over several years
? An extended period is less
subject to distortions,
irregularities,and
other transitory effects
? Preferred time horizon in
measuring earning power is
typically 4 to 7 years
Earning Forecasting
Earning Power and Forecasting
? Mechanics of Earnings Forecasting
? Quantitative Methods—time-series and regression
models
? Judgmental Methods
? Combinations of Quantitative and Judgmental Methods
Earning Forecasting
Earning Power and Forecasting
Factors Impacting Earnings Forecasts
?Current and past evidence
?Continuity and momentum of company performance
?Industry prospects
?Management
Management quality—resourcefulness
Asset management—operating skills
?Economic and competitive factors
?Key Indicators such as
?capital expenditures
?order backlogs
?demand trends
Monitoring and Revising Earnings Forecasts
Earning Power and Forecasting
Available Interim Reports
?Quarterly reports (Form 10-Q)
? Reports on current developments (Form 8-K)
? Disclosure of separate fourth-quarter results
? Details of year-end adjustments
? Interim reports filed with the SEC such as,
?Comparative interim and year-to-date income statement
?Comparative balance sheets
?Year-to-date statement of cash flows
?Pro forma information on business combinations
?Disclosure of accounting changes
?Management’s narrative analysis of operating results
?Reports of a change in auditor
Monitoring and Revising Earnings Forecasts
Earning Power and Forecasting
Limitations with Interim Reports
?Period-End Accounting Adjustments
?Seasonality in Business Activities
?Integral Reporting Method
12
CHAPTER
Earnings Persistence
Recasting and Adjusting
? Earnings persistence is a key to effective equity
analysis and valuation
? Analyzing earnings persistence is a main analysis
objective
? Attributes of earnings persistence include,
Stability
Predictability
Variability
Trend
Earnings management
Accounting methods Analyze
Earnings Persistence
Recasting and Adjusting
Two common methods to help
assess earnings persistence,
? Recasting of income
statement
? Adjusting of income
statement
Earnings Persistence
Recasting and Adjusting
Information for Recasting and Adjusting
? Income statement,including its subdivisions,
Income from continuing operations
Income from discontinued operations
Extraordinary gains and losses
Cumulative effect of changes in accounting
principles
? Other financial statements and notes
? Management commentary in financial statements
? Management’s Discussion and Analysis
? Other,product-mix changes,technological
innovations,work stoppages,and raw material
constraints
Earnings Persistence
Recasting and Adjusting
Objectives of Recasting
1,Recast earnings and earnings components so that stable,normal
and continuing elements comprising earnings are distinguished
and separately analyzed from random,erratic,unusual and
nonrecurring elements
2,Recast elements included in current
earnings that should more properly be
included in the operating results of one
or more prior periods
Recasting and adjusting earnings also
aids in determining earning power
General Recasting Procedures
? Income statements of several years (typically at least
five) are recast
? Recast earnings components to yield meaningful
classifications and a relevant format for analysis
? Components can be rearranged,subdivided,and tax
effected
? Total recasted components
must reconcile to reported
net income
Earnings Persistence
Recasting and Adjusting
Specific Recasting Procedures
? Discretionary expenses are segregated
? Distinct components are segregated (such as equity in income of
unconsolidated subsidiaries) and often reported net of tax
? When components of continuing income are separately
reclassified,their pre-tax amounts along with their tax effects
must be removed
? Income tax disclosures enable one to separate factors that either
reduce or increase taxes such as,
? Deductions—tax credits,capital
gains rates,tax-free
income,lower foreign tax rates
? Additions—additional foreign
taxes,non-tax-deductible
expenses,and state and local
taxes (net of federal tax benefit)
Earnings Persistence
Recasting and Adjusting
Recasting and Adjusting -- Illustration
Earning Persistence
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
13 Net sales $ 6,204.1 $ 6,205.8 $ 5,672.1 $ 4,868.9 $ 4,490.4 $ 4,286.8
19 Interest income 26.0 17.6 38.3 33.2 29.5 27.4
Total revenue $ 6,230.1 $ 6,223.4 $ 5,710.4 $ 4,902.1 $ 4,519.9 $ 4,314.2
Costs and expenses,
Cost of products sold (see Note 1 below) $ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,820.5
Marketing and selling expenses (see Note 2 below) 760.8 760.1 605.9 514.2 422.7 363.0
145 Advertising (see Note 2 below) 195.4 220.4 212.9 219.1 203.5 181.4
144 Repairs and maintenance (see Note 1 below) 173.9 180.6 173.9 155.6 148.8 144.0
16 Administrative expenses 306.7 290.7 252.1 232.6 213.9 195.9
17 Research and development expenses 56.3 53.7 47.7 46.9 44.8 42.2
102 Stock price related incentive programs (see Note 3 below)
15.4 (0.1) 17.4 (2.7) — 8.5
20 Foreign exchange adjustment 0.8 3.3 19.3 16.6 4.8 0.7
104 Other,net (see Note 3 below) (3.3) (2.0) (1.4) (4.7) (0.4) (9.0)
162A Depreciation (see Note 1 below) 194.5 184.1 175.9 162.0 139.0 120.8
103 Amortization of intangible and other assets (see Note 3 below)
14.1 16.8 16.4 8.9 5.6 6.0
18 Interest expense 116.2 111.6 94.1 53.9 51.7 56.0
Total costs and expenses $ 5,557.9 $ 5,712.7 $ 5,266.0 $ 4,480.2 $ 4,132.2 $ 3,930.0
23 Earnings before equity in earnings of affiliates & min,interests
$ 672.2 $ 510.7 $ 444.4 $ 421.9 $ 387.7 $ 384.2
24 Equity in earnings of affiliates 2.4 13.5 10.4 6.3 15.1 4.3
25 Minority interests (7.2) (5.7) (5.3) (6.3) (4.7) (3.9)
26 Income before taxes $ 667.4 $ 518.5 $ 449.5 $ 421.9 $ 398.1 $ 384.6
Income taxes at statutory rate* (226.9) (176.3) (152.8) (143.5) (179.1) (176.9)
Income from continuing operations $ 440.5 $ 342.2 $ 296.7 $ 278.4 $ 219.0 $ 207.7
135 State taxes (net of federal tax benefit) (20.0) (6.6) (3.8) (11.8) (8.6) (8.0)
Investment tax credit — — — — 4.4 11.6
137 Nondeductible amortization of intangibles (4.0) (1.6) (1.2) (2.6) (1.4) —
138 Foreign earnings not taxed or taxed at other than statutory rate
2.0 (2.2) (0.2) 3.2 11.1 15.2
139 Other,Tax effects (17.0) (2.2) (0.1) (3.7) 7.5 (4.7)
Alaska Native Corporation transaction — — — — 4.5 —
22 Divestitures,restructuring and unusual charges — (339.1) (343.0) (40.6) — —
Tax effect of divest.,restructuring & unusual charges (Note 4)
— 13.9 64.7 13.9 — —
(Continued on next page)
Recasting and Adjusting -- Illustration
Earning Persistence
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
Gain on sale of businesses in (Yr 8) and sub,in Yr 7 — — — 3.1 9.7 —
Loss on sale of exercise equipment subsidiary,net of tax — — — — (1.7) —
LIFO liquidation gain (see Note 1 below) — — — 1.7 2.8 1.4
Income before cumulative effect of accounting change$ 401.5 $ 4.4 $ 13.1 $ 241.6 $ 247.3 $ 223.2
153A Cumulative effect of accounting change for income taxes — — — 32.5 — —
28 Net income as reported $ 401.5 $ 4.4 $ 13.1 $ 274.1 $ 247.3 $ 223.2
14 (Note 1) Cost of products sold $ 4,095.5 $ 4,258.2 $ 4,001.6 $ 3,392.8 $ 3,180.5 $ 3,082.8
144 Less,Repair and maintenance expenses (173.9) (180.6) (173.9) (155.6) (148.8) (144.0)
162A Less,Depreciation(a) (194.5) (184.1) (175.9) (162.0) (139.0) (120.0)
153A Plus,LIFO liquidation gain(b) — — — 2.6 5.1 2.6
$ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,821.4
15 (Note 2) Marketing and selling expenses $ 956.2 $ 980.5 $ 818.8 $ 733.3 $ 626.2 $ 544.4
145 Less,Advertising (195.4) (20.4) (212.9) (219.1) (203.5) (181.4)
$ 760.8 $ 960.1 $ 605.9 $ 514.2 $ 422.7 $ 363.0
21 (Note 3) Other expenses (income) $ 26.2 $ 14.7 $ 32.4 $ (3.2) $ (9.5) $ 5.5
102 Less,Stock price–related incentive programs (15.4) 0.1 (17.4) 2.7 — (8.5)
103 Less,Amortization of intangible and other assets (14.1) (16.8) (16.4) (8.9) (5.6) (6.0)
Less,Gain on sale of businesses (Yr 8) and sub,(Yr 7) — — — 4.7 14.7 —
104 Other,net $ (3.3) $ (2.0) $ (1.4) $ (4.7) $ (0.4) $
(9.0)
(Note 4) Tax effect of divest,restruc.,& unusual charges — $ 115.3(c) $ 116.6(d) $ 13.9 — —
136 Nondeductible divestitures,restructuring,and unusual charges
— (101.4)(e) (51.9)(f) — — —
— $ 13.9 $ 64.7 $ 13.9 — —
*Statutory federal tax rate is 34% in Year 8 through Year 11,45% in Year 7,and 46% in Year 6,
?This amount is not disclosed for Year 6,
(a)We assume most depreciation is included in cost of products sold,
(b)LIFO liquidation gain before tax,For example,for Year 8 this is $2.58 million,computed as $1.7/(1 0.34),
(c)$339.1 22 0.34 = $115.3,
(d)$343.0 22 0.34 = $116.6
(e)$179.4 26 0.565 136 = $101.4,
(f)$106.5 26 0.487 136 = $51.9,
Earnings Persistence
Recasting and Adjusting -- Illustration
Objective of Adjusting
Assign earnings components to periods where they
most properly belong
Note,Uses data from recast income statements and
any other relevant information
General Adjusting Procedures
All earnings components must be considered
When a component is excluded from the period when
reported,then
1,Shift it (net of tax) to the operating results of one or
more prior periods,or
2,Spread (average) it over earnings for the period
under analysis
Note,Only spread items over prior
earnings when they cannot be
identified with specific periods
Earnings Persistence
Recasting and Adjusting
Specific (Typical) Adjusting Procedures
? Assign extraordinary and unusual items (net of tax) to
applicable years
? Tax benefit of carryforwards normally moved to the loss year
? Costs or benefits from lawsuit settlements moved to
relevant prior years
? Gains and losses from disposals of discontinued
operations usually relate to operating results of several prior
years
? Changes in accounting principles or
estimates yield adjustments to all
years under analysis to a comparable
basis—redistribute ―cumulative effect‖
to the relevant prior years
? Normally include items that increase or decrease equity
Earnings Persistence
Recasting and Adjusting
Earnings Persistence
Recasting and Adjusting
Campbell Soup Company
Adjusted Income Statements ($ mil.)
Year 11 Year 10 Year 9 Year 8 Year 7 Year 6 Total
Net income as reported $ 401.5 $ 4.4 $ 13.1 $ 274.1 $ 247.3 $ 223.2 $ 1,163.6
Divestitures,restructuring & unusual charges
339.1 343.0 40.6
Tax effect of divestitures,restructuring,etc,
(13.9) (64.7) (13.9)
Gain on sale of businesses (Yr 8) and sale of
subsidiary (Yr 7),net of tax (3.1) (9.7)
Loss on sale of exercise equipment subsidiary 1.7
ANC transaction (4.5)
LIFO liquidation gain (1.7) (2.8) (1.4)
Cumulative effect of change in acctg for taxes (32.5)
Adjusted net income $ 401.5 $ 329.6 $ 291.4 $ 263.5 $ 232.0 $ 221.8
Total net income for the period $ 1,163.6
Average earnings for the period $ 193.9
Earnings Persistence
Determinants of Persistence
Earnings persistence determined by many
factors including,
?Earnings variability
?Earnings trend
?Earnings stability
?Earnings predictability
?Earnings Management
?Management Incentives
Note,Assess earnings persistence over both the
business cycle and the long term
Earnings Persistence
Measuring Persistence
Earnings variability can be measured,
1,Standard variability measures
2,Average earnings--typically using 5 to 10
years of data
3,Minimum earnings--typically selected from
the most recent business cycle,reflecting a
worst-case scenario
Earnings Persistence
Measuring Persistence
Earnings Trend can
be measured,
1,Statistical methods
2,Trend statements
(such as Index numbers)
Earnings Persistence
Measuring Persistence
Earnings Management is reflected as follows,
? Changes in accounting
methods or assumptions
? Offsetting extraordinary
/unusual gains and
losses
? Big baths
? Write-downs
? Timing revenue and expense recognition
? Aggressive accounting applications
Earnings Persistence
Measuring Persistence
Management Incentives affecting persistence include,
? Personal objectives and interests
? Companies in distress
? Prosperous companies—preserving hard-earned
reputations
? Compensation plans
? Accounting-based incentives and constraints
? Analysts targets
Earnings Persistence
Measuring Persistence
Earnings persistence of
components depends on key
attributes
Recurring vs Non-recurring
Operating vs Non-operating
Key application of these
attributes is the reporting of
Extraordinary vs Non-
extraordinary
C o m p a n i e s R e p o r t i n g E x t r a o r d i n a r y I t e m s
N o e x t r a o r d i n a r y i t e m s,
86%
E x t r a o r d i n a r y i t e m s,1 4 %
Earning Persistence
Measuring Persistence
Source,Accounting Trends & Techniques
Earnings Persistence
Measuring Persistence
Analyzing and Interpreting
Extraordinary Items
1,Determine whether an item
is extraordinary (less
persistent) or not
2,Assessing whether an item
is unusual,non-operating,
or non-recurring
3,Determine adjustments
necessary given
assessment of persistence
Earning Persistence
Measuring Persistence
F r e q u e n c y o f E x t r a o r d in a r y I t e m s
0, 0 2, 0 4, 0 6, 0 8, 0 1 0, 0 1 2, 0
De bt e x ting uis hm e nts
Loss carry forw ards
Litigation
" Othe r"
P e rc e n t
Source,Accounting Trends & Techniques
Three broad categories,
1,Nonrecurring operating gains
and losses
-Usually include in current operating
income
2,Recurring non-operating gains and losses
-Consider inclusion in current operating earnings
3,Nonrecurring non-operating gains and losses
-Omitted from operating earnings of a single year
Earning Persistence
Measuring Persistence
Earning-Based Valuation
Stock Prices and Accounting Data
Equity value (Vt)
Book value (BVt)
Return on common equity (ROCEt)
Cost of equity capital (k)
Abnormal earnings = (ROCEt - k) x BVt-1
Note,This model is algebraically identical to the
―residual income‖ model of Chapter 1
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Earning-Based Valuation
Valuation Multiples
Price-to-Book (PB)
e q u it y of va lu e B o o k
e q u it y of va lu eM ar k e t
Earning-Based Valuation
Valuation Multiples
Price-to-Book (PB) expressed in accounting data
Note
?ROCE and growth in book value increase ? PB increases
?Cost (risk) of equity capital increases ? PB decreases
?Present value of future abnormal earnings is
positive (negative) ? PB is greater
(less) than 1.0
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Earning-Based Valuation
Valuation Multiples
Price-to-Earnings (PE)
i n c o m eN e t
e q u i t y of v a l u eM a r k e t
Earning-Based Valuation
Valuation Multiples
Price-to-Earnings (PE) expressed in accounting data
PE [equaling (1+k)/k] is ―normal‖ PE
? Niat+1 is the expected change in abnormal earnings
compared to the prior year (Niat+1 NIat)
dt is dividends
Note
? Cost of equity capital increases ? PE decreases
? Future abnormal earnings increases (decreases)
? PE is greater (less) than normal PE
? Current earnings increases (decreases)
? PE decreases (increases)
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Earning-Based Valuation
Valuation Multiples
Low PB High PB
?Low PE Earnings expected to grow Earnings
expected to grow slowly or decline relative to slowly
or decline relative to current level,with low expected
current level,but with high ROCE,expected ROCE,
?High PE Earnings expected to grow Earnings
expected to grow quickly relative to current level,
quickly relative to current level,but with low expected
ROCE,with high expected ROCE,
Earning-Based Valuation
Earnings-Based Valuation--Illustration
Christy Co,book value of equity at January 1,Year 1,is $50,000
Christy has a 15% cost of equity capital (k)
Forecasts of Christy’s accounting data follow,
Year 1 Year 2 Year 3 Year 4 Year 5
Sales $ 100,000 $ 113,000 $ 127,690 $ 144,290 $144,290
Operating expenses 77,500 90,000 103,500 118,000 119,040
Depreciation 10,000 11,300 12,770 14,430 14,430
Net income $ 12,500 $ 11,700 $ 11,420 $ 11,860 $ 10,820
Dividends 6,000 4,355 3,120 11,860 10,820
Year 6 and beyond = Both accounting data and dividends
approximate Year 5 levels
Earning-Based Valuation
Earnings-Based Valuation--Illustration
Christy’s forecasted book value at January 1,Year 1 is
$58,594—computed as,
This implies Christy stock should sell at a PB ratio of 1.17
($58,594/$50,000) at January 1,Year 1
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Earning-Based Valuation
Earnings-Based Valuation--Illustration
Two additional observations are important,
1,Expected ROCE equals 15% (Christy’s cost of capital) for Year 5
and beyond,Since ROCE equals the cost of capital for Year 5 and
beyond,these years’ results do not change the value of Christy (that
is,abnormal earnings equal zero for those years),The anticipated
effects of competition are implicit in estimates of future profitability,
2,Valuation estimates assume dividend payments occur at the end of
each year,A more realistic assumption is that,on average,these
cash outflows occur midway through the year,To adjust valuation
estimates for mid-year discounting,multiply the present value of
future abnormal earnings by (1 k/2),For Christine Company the
adjusted valuation estimate equals $59,239,This is computed as
$50,000 plus (1 1 [.15/2]) 3 $8,594,
Earning Power and Forecasting
Earning Power
Earning power is the earnings level expected to persist
into the foreseeable future
? Accounting-based valuation models capitalize
earning power
? Many financial analyses
directed at determining
earning power
Earning Power and Forecasting
Earning Power
Measurement of Earning Power reflects,
? Earnings and all its components
? Stability and persistence of earnings and its
components
? Sustainable trends in
earnings and its
components
Earning Power and Forecasting
Earning Power
Factors in selecting a time horizon for measuring earning
power
? One-year period is often too short to reliably measure
earning power
? Many investing and financing activities are long term
? Better to measure earning power by using average (or
cumulative) earnings over several years
? An extended period is less
subject to distortions,
irregularities,and
other transitory effects
? Preferred time horizon in
measuring earning power is
typically 4 to 7 years
Earning Forecasting
Earning Power and Forecasting
? Mechanics of Earnings Forecasting
? Quantitative Methods—time-series and regression
models
? Judgmental Methods
? Combinations of Quantitative and Judgmental Methods
Earning Forecasting
Earning Power and Forecasting
Factors Impacting Earnings Forecasts
?Current and past evidence
?Continuity and momentum of company performance
?Industry prospects
?Management
Management quality—resourcefulness
Asset management—operating skills
?Economic and competitive factors
?Key Indicators such as
?capital expenditures
?order backlogs
?demand trends
Monitoring and Revising Earnings Forecasts
Earning Power and Forecasting
Available Interim Reports
?Quarterly reports (Form 10-Q)
? Reports on current developments (Form 8-K)
? Disclosure of separate fourth-quarter results
? Details of year-end adjustments
? Interim reports filed with the SEC such as,
?Comparative interim and year-to-date income statement
?Comparative balance sheets
?Year-to-date statement of cash flows
?Pro forma information on business combinations
?Disclosure of accounting changes
?Management’s narrative analysis of operating results
?Reports of a change in auditor
Monitoring and Revising Earnings Forecasts
Earning Power and Forecasting
Limitations with Interim Reports
?Period-End Accounting Adjustments
?Seasonality in Business Activities
?Integral Reporting Method
